On Aridni, we all want our assets to grow, but generally larger returns require a greater risk to achieve them. If you have a pile of cash sitting in the bank, but are afraid to invest it for fear of losing the principal, you have good reason to worry, but only if you don’t know what you’re doing.
Here’s an example: In the summer of 1999, my father invested the approximately $1 million from the sale of our old house into the stock market only to lose the vast majority of it when the market crashed the next year. My father blamed the loss on the 2000 presidential election and everything else under the sun except for the real culprit: he did not diversify his investments. In addition, he invested (and therefore risked) the entire $1 million. As a result, my father, who is self employed, will never be able to retire.
Not wanting to repeat my father’s mistakes, I recently sought my Aunt Jaymie’s advice on how to manage my own money since she is a Merill Lynch financial advisor and manages the investments of wealthy clients for a living. According to my aunt, there are many options for saving money, some of the most common of which are listed below. Once you understand the rules, it becomes easier to play… and win the game.
Certificate of Deposits (CDs)
What They Are: A CD is a secure, risk free option offered by most banks. It allows you to gain a small return on your money without risking any of the principal. Your money is tied up for a specified period of time- usually anywhere from several months to a year or two. Unless you open a risk free CD, you pay a penalty if you take out the money before the CD reaches maturity.
Advantages: Unlike other investment options, with a CD you know exactly how much you will earn when it matures and while you may not earn that much, your principal is protected. CDs are also FDIC insured (assuming your CD is with a bank that is a member of the FDIC). Unlike a 401K or IRA (see below) you get returns in a short period of time and your money is not tied up as long.
Drawbacks: Your returns are minimal (my risk free CD at Bank of America is giving me a return of only 4.12%). You have to pay taxes on CDs, so consider whether after taxes, you will still have made a profit.
Who Should Consider Them: If you have a lump sum of cash sitting in the bank and anticipate needing it in the next few years, but want to make some money off of it in the meantime, this option is for you. A CD would have been a great option for my dad.
What They Are: 401Ks are offered as an employee benefit by many companies as a way to help people save for retirement. You decide how much of each paycheck is deposited into your 401K and at the age of 65.5 you can take the money out and do with it what you want. When you sign up for a 401K, you determine where you want the money invested and your employer takes care of the rest for you.
Advantages: The biggest advantage of a 401K is that it contains pre-tax dollars- a huge plus come April 15th! Only after the 401K matures, are you required to pay taxes on it. Should you change employers, you can take your 401K with you, another huge advantage of this investment tool. The return on 401Ks is substantial and some companies even match the amount you invest each pay period.
Drawbacks: As with any investment, there is a chance you will lose the principal, so don’t invest more than you can afford to lose. You also cannot touch the money until you reach age 65.5, so avoid investing money you anticipate needing in the near future unless you are prepared to pay a 10% penalty. 401Ks are not available to those of us who are self employed, so if you fall into that category, consider opening an IRA (see below).
Who Should Consider Them: Everyone who has a 401K available to them should take advantage of this great option. In today’s world, with social security becoming less secure, it is important to take control of your own retirement.
Individual Retirement Accounts (IRAs)
What They Are: IRAs are an alternative to 401Ks for self employed individuals or for people who already have a 401K and want to add diversity to their pool of investments. Each cent you deposit into an IRA must come from your own income. So if your Aunt Susy left you a bunch of cash, that money cannot go into your IRA. IRAs are tax deferred and the particular terms and conditions of your IRA depend on the type you open. There are many kinds of IRAs ranging from traditional to ROTH.
Who Should Consider Them: Everyone should consider IRAs, especially if you don’t have a 401K available to you. My Aunt Jaymie even says it is advisable for recent college graduates like myself to open one as a way to start saving early for retirement.
So what should my father’s investment portfolio looked like in order to maximize his returns and minimize the risks? My aunt thinks he should have put half a million in a CD and the other half in an IRA.